One Bank Asks: Where Is All This Fucking Leverage Coming From?

Lots of pretty smart people are talking about corporate leverage.

More specifically, some folks are concerned about corporate leverage in the US, where the central bank-inspired hunt for yield has created an insatiable appetite for corporate supply. Management has been more than happy to feed investors’ appetite by issuing debt, the proceeds from which have been funneled into buybacks. That’s supposed to be a kind of win-win scenario. It artificially inflates corporate bottom lines, creates an artificial bid for stocks, and, happily, inflates management’s equity-linked compensation.

Of course it also amounts to financial engineering of the worst kind as companies leverage the balance sheet in pursuit of short-term goals at the (possible) expense of long-term sustainability.

But you know, “fuck it,” right?

Some desks (Morgan Stanley being perhaps the most notable), have suggested that this dynamic is dangerous if we’re late cycle. More recently, the IMF warned that the pricing of corporate risk has become detached from those same corporates’ ability to service their debt (especially in HY). And SocGen’s Andrew Lapthorne has been screaming from the rooftops about how unsustainable this is (see here and here, for example) for months.

Well, Citi’s Hans Lorenzen decided to take a deep-dive into this apparent problem. In his second note in the space of a week (which, for Hans, is something of a land-speed record), one of the Street’s best credit analysts sets out to answer an ostensibly simple question: “have we passed peak leverage in the US & Europe?”

Excerpts from the note can be found below.

Via Citi

At face value, leverage is such a simple concept. Corporates borrow and creditors judge their ability to repay it by comparing the amount borrowed to earnings and price their debt accordingly. However, appearances can be deceptive. Any measure of leverage needs to be treated with great care, especially when aggregated to a market level.

Which are more leveraged – US corporates or European corporates? After five years of huge debt-funded shareholder payouts, most people would probably argue the former with great conviction. But it is not as simple as that. It all depends on what’s included and how the contribution of each company is weighted. There is a very credible case that corporate leverage is and always has been considerably higher in Europe than in the US.

In Figure 2 below, we have quite simply summed up the individual net debt levels of just over 500 of the largest non-financial corporates in Europe and divided by the sum of their individual EBITDAs over the last four quarters. In the US, we have done the same for more than 400 past and present non-financial constituents of the S&P 500. On that basis corporate leverage stands at 2.2x in Europe versus only 1.6x in the US. In terms of spread per unit of leverage, this makes the European market look very expensive to the US and to history (Figure 3).

CitiLeverage

Summing up the individual contributions implicitly means that larger companies and sectors carry greater weight than a leverage measure which ignores size, such as a median. That therefore distorts any comparison, because of differences in composition.

Corporate US is less exposed to sectors like autos and utilities, where leverage tends to be comparatively high than corporate Europe (Figure 4). Conversely, it is more heavily weighted towards consumer goods and services and TMT (i.e. tech), where leverage tends to be low – think Google and Amazon. Indeed, merely taking the TMT sector out raises US corporate leverage to about 2.2x – the same level as in Europe.

In fact, in a sector by sector comparison, US corporates are more leveraged than their European peers in most sectors (Figure 5).

So perhaps perceptions were not that far off the mark after all, but it shows how a leverage number in reality is much less definite than it appears unless you know what went into it and what’s driving changes.

CitiLeverage2

Have European corporates really leveraged up as much as US peers?

Look back at the leverage numbers (Figure 2) and there is another equally surprising finding. Both European and US corporates have leveraged aggressively over the last five years and reached a record level in Q4 2015, from which there has since been a modest retracement.

While this seems to confirm the widely held perception that US companies have been deluging their shareholders with debt-funded payouts, it flies in the face of the consensus view that European companies have been keeping their powder dry. Yet the latter is not so much a question of sectoral composition as one of size.

The releveraging in Europe is genuine, but unlike in the US is very concentrated on a few large names. Median leverage in Europe, which isn’t weighted towards the large caps, has risen too, but only as much as weighted leverage in the US, albeit from a lower base (Figure 6).

In fact, the rise in leverage in Europe is almost exclusively down to the largest 25 companies measured by total EBITDA from 2011 to 2016. While their leverage has more than doubled over that period, leverage for the remaining 480 companies has barely moved 0.2 turns from the cyclical low in 2011 (Figure 7).

Citileverage3

So the perception that most European companies have remained conservative isn’t wrong, but it doesn’t tell the full story. A subset of very large companies with a big weighting in debt markets have behaved very differently.

Who are those 25 companies? Seven are in oil & gas and basic resources, where debt rose sharply early in the cycle and earnings subsequently collapsed with commodity prices. Three are auto companies, where the debt of the financial services business has expanded significantly (which obviously isn’t the same as conventional corporate leverage), and among the remainder are some of the large acquirers in recent years, like AB InBev.

At the sectoral level, the leverage picture in Europe is not very exciting (Figure 8 and Figure 9). The surge in leverage in commodity sectors in 2015 as a result of slumping earnings is now reversing. And the only sectors where there has been a meaningful increase in leverage are industrials and consumer goods and services, but both are from a very low base.

Citileverage4

In the US, the releveraging has been much broader. As noted above, in this case there is little difference in weighted and median leverage trends. The largest companies have not behaved all that differently from the rest of the US corporate universe. More than three-quarters of companies now operate with higher leverage than in 2011, compared with only just over 50% in Europe.

Where is the rise in leverage coming from?

Looking at the indexed evolution of earnings and net debt, along with revenues (Debt, revenues & EBITDA trends – indexed sum Figure 10 – Figure 12) makes the differences clearer still.

US corporates have kept earnings in line with revenues, but both have lagged net debt accumulation considerably, resulting in higher leverage.

The largest 25 companies in Europe have increased net debt even faster than their US peers – by no less than 125% over the last decade, even as revenue growth has lagged the US and earnings have lagged revenues (i.e. margins have fallen). In fact, their EBITDA is still below the level of 10 years ago. The earnings drop is, of course, in large part due to the heavy presence of commodity companies in the top- 25, but the rise in borrowing is much broader.

In contrast, the remaining 90%+ of European companies have barely increased net debt by more than 25% over the same period. And though they too have seen margin pressure, their revenues have held up much better, surpassing even the US average.

For both European and US corporates, the stabilization in leverage in 2016 reflects both a recovery in earnings as well as a levelling out in net debt.

CitiLeveraeg5

There’s much, much more in the full piece, but that’s the gist of it.

And we think you probably get the idea which is, in short, that while there’s some nuance involved, the story is the same as it ever was.

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